Why your allocation to EPF should not change despite interest rate cut

The interest rates within the economy are at much lower levels. Long-term government securities maturing in 2061 offer a coupon of around 6.95 per cent currently. The Employees’ Provident Fund also makes a small allocation to equities -- 15% of incremental flows.

So the reduction in EPFO’s rate of return was inevitable. And this trend towards lower rates may continue in the future.

However, EPF’s 8.1% return continues to be attractive. Its rate of return on the tax-free portion is higher than what other fixed-income alternatives are offering.

Remember that there are two components to the return from EPF (and VPF, or Voluntary Provident Fund). Contributions of up to Rs. 2.5 lakh are tax free.  

Contributions above Rs. 2.5 lakh are taxed at slab rate. The post-tax return would come to around 5.67% for someone in the 30% tax bracket, around 6.48% for someone in the 20% tax bracket, and 7.7% for someone in the 5% tax bracket.

For an apple-to-apple comparison, we should compare the returns from EPF with other government-backed instruments which give a guaranteed and safe return and can be used during the accumulation phase for retirement planning.

The nearest such instrument is the Public Provident Fund (PPF), which offers 7.1 per cent tax free. This is much lower than the return on the tax-free component of EPF.

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Another instrument is the RBI’s Floating Rate Bond, which offers 7.15%, but this is taxable at slab rate.

The National Pension System (NPS), a retirement saving product, is not a comparable instrument. It is government backed but offers market-linked returns.

Another option is Sukanya Samriddhi Yojana. It is a government-backed instrument, which can be used for long-term savings. It offers 7.6 per cent rate of return which is tax free. But this is available only to people who have a girl child.

Products like Senior Citizens Savings Scheme (SCSS) and Prime Minister Vaya Vandana Yojana (PMVVY) offer 7.4% return, but these are taxable. Moreover, these instruments are meant for income generation and not for the accumulation phase.

Debt mutual funds are tax efficient, but they are not government backed, and their returns are market-linked. Yield to maturity (YTMs) for most debt fund categories are in the 5.5-6 per cent range currently.

Don’t change your investment strategy just because EPF’s rate of return has been reduced by 40 basis points. EPF has one shortcoming. It is predominantly a debt instrument.

If your retirement is a long time away, you should primarily have equities in your retirement portfolio. You could use the NPS, where you can allocate up to 75 per cent to equities (provided your risk appetite allows).

You can also use active and passive equity mutual funds. While equities can be volatile in the short term, they offer better returns than fixed-income instruments over the long term.

In a retirement portfolio, you would want some -- say 10 or 20% allocation -- to fixed-income instruments. EPF and PPF should constitute that portion of your retirement portfolio.

Avoid the mistake of over allocating to EPF, just because it is government-backed and completely safe. If you do so, you will not have adequate money left to invest in equities, which is the ideal asset class that can beat inflation and help you retire with a hefty corpus. 

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